PowerShares Plans RAFI ETF Push

PowerShares, the Chicagoland ETF issuer behind the ultra-popular QQQ that has expanded its presence in the alternative weighting arena in recent years, has plans to significantly expand its partnership with Research Affiliates, the firm that developed the RAFI methodology. Next month, PowerShares will convert seven existing products from its “Dynamic” ETF suite to Fundamental Pure Style ETFs that seek to replicate RAFI benchmarks. In addition, the company will introduce two new ETFs, including the PowerShares Fundamental Pure Large Growth Portfolio (NYSEARCA:PXLG) based on the RAFI Fundamental Large Growth Index and the PowerShares Fundamental Pure Large Value Portfolio (NYSEARCA:PXLV) based on the RAFI Fundamental Large Value Index. Following the shakeup, the PowerShares Fundamental Pure Style suite will include nine ETFs:

While many of the largest equity ETFs are linked to market capitalization-weighted benchmarks, ETFs have facilitated an increase in interest in alternative weighting methodologies. The Research Affiliates Fundamental Index (RAFI) methodology is one of the techniques that has grown in popularity in recent years, as a number of ETFs linked to RAFI benchmarks have delivered impressive performances and accumulated significant assets under management.

The RAFI weighting methodology is relatively straightforward. Whereas cap-weighted indexes generally determine components and individual allocations based on market capitalization (i.e., shares outstanding times price per share), this alternative considers multiple fundamental factors to determine a stock’s weight in the index. Specifically, cash flow, book value, sales and dividends are used as inputs to determine the “RAFI weight,” effectively breaking the link between share price and weight within an index. While cap weighting features a number of advantages - such as low maintenance and an inherent momentum focus - there are some potential drawbacks as well. Cap-weighting has a tendency to overweight overvalued stocks and underweight undervalued ones, a bias that obviously has the potential to create a drag on returns. A look at the performance of various large cap ETFs in 2010 highlights the impact of weighting methodologies on bottom line returns; SPY lagged behind many of the alternatives that employ alternative strategies for determining the weighting afforded to each component company.

“The idea behind a fundamental index was one of weighting companies according to their size in the economy,” Research Affiliates founder Rob Arnott told ETF Database in an interview earlier this year. “So that instead of looking at an index that looked like the composition and structure of the stock market, you would instead have a portfolio that looked like the composition and structure of the economy.”

Ditching Dynamic ETFs

With the move toward RAFI-weighted ETFs, PowerShares will shrink its lineup of “Dynamic” ETFs that sought to replicate a family of “Intellidex” benchmarks. Those products blurred the line between active management and passive replication strategies. The ETFs sought to replicate a benchmark, but the underlying index employed a proprietary quant-based screening process to identify companies with the greatest potential for capital appreciation.

The methodology behind the Intellidex benchmarks has experienced limited success since launch, as many of the PowerShares size/style products have failed to match (let alone beat) cap-weighted benchmarks (see database of ETF indexes). Of the seven Dynamic PowerShares ETFs that will be re-branded as part of the Fundamental Pure Style Suite, only the Dynamic Large Cap Portfolio (PJF) has beaten the comparable cap-weighted S&P benchmark since fund inception. Some of the performance gaps have been significant; the Dynamic Mid Cap Portfolio (PWJ) has lagged the S&P MidCap 400 by more than 450 basis points annually since inception in late 2006:

Many of the ETFs profiled above have struggled to accumulate assets over the last five years of so; only PWJ and PWT have AUM of greater than $100 million. On the other hand, many of the RAFI benchmarks have exhibited exceptional performances in recent years, in many cases helping to attract significant assets. “We currently offer six equity ETFs based on the RAFI Fundamental Index methodology. The funds have all outperformed their benchmarks since their respective inception dates,” said John Feyerer, Head of Product Strategy and Research at Invesco PowerShares, in a press release. “We believe this methodology has shown the potential to produce improved risk-adjusted returns compared to cap-weighted benchmarks.”

PowerShares will still offer a number of sector-specific ETFs linked to Intellidex benchmarks.

Disclosure: No positions at time of writing, photo courtesy of Joe Ravi.

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